Systematic Relative Strength

The problem with bad economic or financial theories is that they just won’t die! Policy makers (and investors, in the case of modern portfolio theory) continue to rely on them long after they have been repeatedly discredited. The latest example of this is the Phillips Curve:

William Phillips, a New Zealand born economist, wrote a paper in 1958 titled The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, which was published in the quarterly journal Economica. In the paper Phillips describes how he observed an inverse relationship between money wage changes and unemployment in the British economy over the period examined. Similar patterns were found in other countries and in 1960 Paul Samuelson and Robert Solow took Phillips’ work and made explicit the link between inflation and unemployment: when inflation was high, unemployment was low, and vice-versa.

In the years following Phillips’ 1958 paper, many economists in the advanced industrial countries believed that his results showed that there was a permanently stable relationship between inflation and unemployment. One implication of this for government policy was that governments could control unemployment and inflation with a Keynesian policy. They could tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. For example, monetary policy and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates.

Here’s the rub: Brian Domitrovic in Forbes points out that today’s Nobel Prize in Economics went to Sargent and Sims, who discredited the Phillips Curve, and not for the first time!

This morning when Thomas Sargent of New York University (along with Christopher Sims of Princeton) won the Nobel Prize in economics, it marked the lucky seventh time the Nobel has been given for work critical of the “Phillips curve.” The Phillips curve being one of the greatest of Keynesian warhorses. It’s a graph that was developed in the 1950s showing a trade-off between unemployment and inflation. When one goes up, the other goes down.

Readers of this column will recall that back in March I had occasion to marvel that six Nobels – if you’re counting, for Edmund Phelps, Edward Prescott, Robert A. Mundell, Robert E. Lucas, Milton Friedman, and F.A. Hayek – dating back to 1974 have been given for torching the Phillips curve.

Zombie economics, indeed. By Forbes’ count, this is the seventh Nobel disproving the Phillips curve! But here is the most amazing thing:

Yet Sargent’s prize remains pertinent. Just last month, the president of the Chicago Federal Reserve, Charles Evans, strongly implied that the Fed should fight unemployment with a gusto worthy of the Phillips curve; the president’s former top economist, Christina Romer, has been extolling its virtues lately; and it very much seems to be part of Fed Chairman Ben Bernanke’s toolkit through the Quantitative Easings and Operation Twists.

Regardless of its falsehood, economists still want to enact policy as if it were actually true! There’s an old joke about economists being especially economical with theories—they make one last a lifetime.

Zombie theories present a problem for investors, whether it comes in the form of a porfolio constructed using traditional strategic asset allocation or in the guise of completely unpredictable economic outcomes based on pushing a failed theory. The problem is that you can be pretty sure there will be some kind of problem—after all, the theories don’t work—but you have no idea what shape the problem will take. Neither the investor nor the policy wonks know exactly what the outcome will be.

To me, this is a very strong argument for tactical asset allocation driven by relative strength. Relative strength allows you to adapt and respond to whatever the outcome is, expected or unexpected. Investors can’t control policy makers’ decisions, so they must have a robust way to adapt.

Source: depositphotos.com